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Money Management

Future Fund begins revamp of public equities portfolio

Australian giant aims to get more bang for the buck

Future Fund Chairman Peter Costello
Chairman of the Australian Government Future Fund, Peter Costello

Asset owners in Asia are working to better tie the fees they pay equity managers to pure skill, rather than market movements, in anticipation of tougher times ahead.

That quest has remained on their agendas even as markets have continued to defy gravity in recent quarters.

Japan's 144.8 trillion ($1.3 trillion) Government Pension Investment Fund is renegotiating the fees it pays its equity managers fees now with the goal of only paying “for alpha,” said Hiromichi Mizuno, the fund's chief investment officer, at a Milken Institute Global Conference in California on May 3, two months after the GPIF reported a record gain of 8%, or $90 billion, for the final quarter of 2016.

Likewise, two weeks after Australia's A$129.6 billion ($98.1 billion) Future Fund reported a healthy 10.5% return for the 12 months through March 31, Chief Investment Officer Raphael Arndt, in a March 5 speech at an investment forum, outlined a “new approach” — in part aimed at ensuring managers are only paid for “true stock-picking skill” rather than beta or factor-style bets – which the Melbourne-based fund is putting in place for its A$38 billion listed equity program.

Management consulting firm Oliver Wyman and Morgan Stanley (MS) & Co., in a mid-March report, predicted a low-return environment in coming years will leave asset management firms facing “intense fee pressure,” resulting in a 3% decline in industry revenue between 2017 and 2019.

A significant compression of forward-looking returns makes “fee drag … a much more significant issue” today, Mr. Arndt said in his speech. In combination with technology that allows asset owners to better understand their underlying exposures — and determine, for example, whether a manager is earning active fees for delivering returns that can be inexpensively obtained via a value or quality factor index — that prospective drag requires “a new approach to active equities investing,” he added.

In a May 11 interview, Mr. Arndt described that new approach as more “incremental improvements” than “big bang.” It looks to take advantage of that technology to analyse investment exposures to better set the parameters for the portfolio the fund is looking to build, whether in terms of factor exposures or the risk budget to be deployed.

One issue the Future Fund's multiyear equity revamp will look to address is the degree to which the active investment decisions of managers end up offsetting one another, leaving the fund paying active management fees for “what we've found,” at the total portfolio level, is “not significantly different” from market beta, he said.

“Improvements in our technology and systems will enable us to identify offsetting positions…(paving the way for) a richer conversation with our managers to better understand where there are positions, styles or factors that are offsetting each other,” said Mr. Arndt. While there can be good reasons for offsetting positions, such as different time horizons, this “enhancement in technology will provide us with greater insight into the portfolio, and consequently more control over the portfolio,” he said.

Another of the fund's answers to offsetting positions could bring cheer to a segment of the money management industry that's been a lightning rod for fee-related criticism in recent years.

In his speech, Mr. Arndt said “pure stock-picking skill has the best opportunity to thrive when given the broadest canvas possible,” and such skill “is most likely to be found in relatively small-capacity managers looking at global stocks with long-short market neutral mandates.” In the subsequent interview, the CIO said those “smallish long/short managers,” with maybe 30 stocks apiece in their portfolios, would be less likely to cancel each other out.

While the Future Fund's listed equity program has been predominantly long only, a “modestly sized” long/short position was added in 2010, he noted. Since that year, the fund's annual report has included Blackstone Alternative Asset Management, the hedge-fund-of-funds business of New York-based Blackstone Group LP, as one of its global equities managers.

In the May 11 interview, Mr. Arndt said the equity program's long/short position is “in the billions.” At less than 10% of the listed equity program, it's “not material from a capital allocation point of view” but it is material from a risk perspective, he said.

The equity program's long/short portion is separate and distinct from the fund's reported hedge fund allocations of A$19.6 billion, or 15.1% of the portfolio, as of March 31, up from 14.2% at the close of the prior quarter.

The Future Fund is determined to get “more bang for its listed equities buck,” but that doesn't mean it's hell bent on lowering overall fees, said Mr. Arndt. Skill is rare and “we would be quite willing to pay performance fees for managers delivering that skill,” he said.

“People might say the pay load will be bigger than long only,” but in terms of the fee paid per unit of skill, instead of for factor exposures or beta, the fee drag is less, not more, he said.

While Mr. Arndt pointed to the passive global beta substrategy of the fund's new approach - led by AP4 veteran Bjorn Kvarnskog, who joined Future Fund as head of equities in October 2015 - as the most significant of the listed equities program's five substrategies, he went on to note that active equity exposure has ranged historically from 40% to 60% of the A$38 billion total.

The other substrategies are global alternative betas, Australian equities, emerging markets equities and global alpha.

For the long-only active portion of the listed equity program, Mr. Arndt said, as with the hedge fund program, the Future Fund is willing to back “new and emerging managers,” with histories as young as one or two years, noting such firms often have greater incentives to perform than bigger, long-established firms.

“We envisage that quality active managers in our program can co-exist with the introduction of a number of small and emerging managers,” he said.

At the macro-level, the Future Fund's listed equities program is its most important lever for raising or lowering the total portfolio's risk exposure, in response to the investment team's views on global risks and rewards. As of March 31, listed equities accounted for 29% of the portfolio, down from 42.5% in early 2014.